When a foreign corporate or government entity borrows in dollars, they sell those dollars for their local currency to use as they please. A lot of dollar borrowing means a lot of dollar selling, or shorting of the dollar, because those dollars they borrowed are not theirs. Repaying those dollar loans means reversing those dollar shorts. If the repayment pace picks up, catalyzed by rising U.S. dollar interest rates, it can cause a synthetic short squeeze, as it’s doing at the moment.

Treasurys aren’t the solution

My knee-jerk response is to suggest that Treasurys
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would be the obvious safe haven in an emerging markets crisis prompted by a spiking dollar, but this formerly sound safe haven is complicated by the Federal Reserve’s policy of quantitative tightening, which ironically is helping the dollar spike.

The Fed is letting over $200 billion run off the Fed’s balance sheet this year, and if there is no emerging markets or eurozone crisis, they will let about $600 billion run off the balance sheet next year. In other words, they will let those bonds mature and not reinvest the proceeds. That’s a lot of demand for Treasurys that used to exist that will disappear. Looking at the Fed’s balance sheet on a three-year chart (see here), it looks like it is experiencing a rather disconcerting bear market.

Some have compared the Fed’s balance sheet to the U.S. stock market (as represented by the Dow Jones Industrial Average
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) with the suggestion that the Fed “printing money” through quantitative easing (QE) has made stocks and bonds rally, so now that QE has ended and we have quantitative tightening (QT), the stock and Treasury markets should decline. This is an overly simplistic explanation, because QE does not technically involve printing (see chart).

QE vs. QT

The Fed’s QE was the largest carry trade in the world, as it used the cost of financing the excess reserve interest rate to “carry” $4.5 trillion in bonds and remit the interest rate differential to the U.S. Treasury, while suppressing long-term interest rate levels in order to help the economy recover from a bad recession. It is my professional opinion that some very smart people with PhDs in economics did not understand how QE worked when it was introduced, and while some of those PhDs have made some progress on the QE front, many still don’t understand it. This is precisely why we get this “printing” talk.

QE was a practice of aggressively creating excess reserves in the financial system in order to force-feed credit into a banking sector and into an economy under severe stress. While I don’t like such aggressive monetarist operations from a purely philosophical perspective, it did work to a large degree. In order for it to completely work out, quantitative tightening needs to be successful. You can’t have QE work if QT fails, as those are the opposite sides of the same coin. Those excess reserves are now being drained by reverse repurchase agreements and the Fed’s balance sheet is shrinking because they are letting bonds run off.

The problem with ‘shrinkage’

This “shrinkage,” to use a favorite “Seinfeld” term, is a problem for calling the Treasury market a “safe haven” at the moment. If the Fed backs off on the balance sheet shrinkage front, then Treasurys will quickly regain their mojo as a safe haven. There were some pretty aggressive moves to the upside in the U.S. Treasury market as Italian bonds sold off and German bunds rallied last week. If the Fed backs off — and that would not be unheard of in a financial crisis — then long-duration Treasurys will be moonshots. In my opinion, the best way to capitalize on such moves is via zero-coupon bonds.

I will be staying away from leveraged Treasury ETFs as buy-and-hold investors could be whipsawed by the reverse compounding that causes both bullish and bearish ETFs to decline over the long term if the assets they leverage up stay flat but zig-zag around in a range. Leveraged ETFs are for short-term trading only.

Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates. The opinions expressed are his own.

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